The Changing Landscape of Private Equity

While I see pockets of opportunity, overall the industry is maturing and commoditizing as huge amounts of capital continue to flow into the hands of private equity and venture firms.

Like all industries that mature, I see private equity bifurcating into highly specialized and sector-specific funds or large asset management firms like Carlyle and Blackstone. The world of generalist, middle-market funds is shrinking, as seen in the demise of several previously successful firms.

The smaller funds enjoying the greatest success today are highly specialized and sector-specific, combining strong operating skills with deep industry relationships to source deals and drive performance. Meanwhile, the large asset management firms leverage their scale, relationships and global resources to identify attractive investment opportunities around the world. The big will continue to get bigger, and the specialized will continue to get more specialized.

What It Will TakeTo thrive in this increasingly competitive environment, our industry needs to continue to innovate.

When you look back at the history of private equity, there are firms that came up with new and innovative ways to invest. You had models that leveraged young and aggressive professionals to cold-call companies and drive proprietary deal flow. More recently, we've seen the evolution of highly specialized and operationally oriented firms that leverage their industry relationships to source deals and their operational capabilities to drive improved performance in business.

Overall, however, our industry is not very good at innovating. While we ask the management teams of our portfolio companies to innovate and be strategic, we are slow to adapt and change. This is due in part to the way our investors or limited partners evaluate us when deciding whether they want to re-up their commitments. In general, they want consistency in the team, structure and investment strategy, which reinforces the status quo.

Room for Innovation?I break down the private equity investment process into five key parts. On the front end we have idea generation, where we come up with investment themes and draft white papers to drive proactive strategies. Deal sourcing and execution follow. Then, once we own a portfolio company, we have portfolio management driving the path to value. Finally, there is exit planning and execution.

Mckinsey published a study breaking down where investment returns were driven among a sample of 60 portfolio companies across 11 different private equity firms. The three categories were financial arbitrage, sector/market appreciation (getting the market right) and company outperformance (achieving the path to value). The study showed that 63% of returns were driven by operational execution, 32% by getting the market right and only 5% by financial arbitrage.

What this tells me is that deal execution and exit planning and execution are now table stakes for our industry. While still extremely important, they are the commodity part of our investment process that don't really drive ultimate returns. Yet this is the traditional skill set that most private equity professionals possess and value the most.

Strength in Diversity In today's environment, I believe idea generation and portfolio management are the two most important and value-additive parts of the investment process. This is why not one of the last five professionals Baird Capital has hired has a conventional Wall Street background.

We are making a concerted effort to diversify the makeup of our investment team to better reflect the skills and capabilities required to drive stronger idea generation and better portfolio management. I am also convinced that diversity in terms of gender, ethnicity and socio-economic backgrounds helps avoid "group think" scenarios, leading to better and more comprehensive decision-making.

I am not suggesting the total demise of the financial jock in the world of private equity. However, I am saying our industry needs to innovate in terms of our organizational design and the construction of our investment teams to better reflect how value is created.

I believe we will see more operating professionals, strategy consultants, and functional and industry experts joining private equity firms in the coming years. And they will hold an increasing share of the influence and decision-making authority within those firms. I am confident that the next leader of my business will have a very different background than my own. And I don't see how firms that fail to recognize and embrace this trend can survive, let alone thrive.

Gordon Pan is the Managing Partner of Baird Capital. He began his career as a financial analyst on Wall Street and has worked in private equity as both a partner and a strategic consultant.